Breaking the long-only barrier
loosening the constraints Investment managers face many different constraints, usually in the form of investment guidelines. Some constraints are necessary and desirable, like having a risk budget for an investment mandate. Others are less desirable such as those imposed by the markets themselves. Perhaps the most restrictive of these various constraints is the no shorting rule, as it dramatically reduces a fund managers opportunity set for investment. It is likely that investors can realise a potentially large alpha benefit by relaxing the long-only constraint, i.e. no shorting in an equity portfolio. This benefit arises from the market-cap weightings of standard equity benchmarks and the long-only portfolio manager’s inability to profit from negative views on companies with low index weights.
No rewards for backing a loser If you consider a portfolio managed relative to the S&P 500 Index. The 263 smallest stocks in the S&P 500 all have less than a 0.1 per cent weight in the index. They collectively make up 53 per cent of the index by number, but only 14 per cent of the index by weight. A long-only investment manager with a negative view on one of these stocks can only be 0.1 per cent underweight or less. Even if a manager is largely right about a negative view, and the shares halve in price, the maximum contribution to portfolio return is only 5 basis points. With a positive view on the company, that same long-only manager is free to overweight the shares by 1 per cent or more, constrained only by the portfolio’s risk budget targets and single stock exposure limits. A doubling of the share price could add 50 basis points or more to the portfolio return. This asymmetry between the large reward for a correct positive view and the small reward for a correct negative view penalises managers who are equally skilled at picking winners and losers. As a result, many equity portfolio managers do not focus on picking losers because the potential rewards are so small. Not surprisingly, given this lack of focus, the best opportunities to create alpha may come from underweighting losers. The no short constraint has other implications as well. Specifically, it makes risk management more difficult because the manager cannot easily hedge certain risks without going short. For example, if a large-cap manager finds higher alphas in the smaller names within his or her benchmark, it would be simple to invest in these names and hedge any size bias by simultaneously shorting the less attractive smaller names in the benchmark. With a long-only constraint, however, this risk is harder to hedge, forcing the manager to accept size risk or forego alpha opportunities. Not all constraints are created equal Whilst constraints exist for good reason and can be an important backstop, they are not all created equal. Good features about constraints are when they are consistent with the portfolio’s risk target and, in turn, the manager’s risk budget and skill set. Where they can be negative is when they are unnecessary and constrain potential outperformance. Breaking the long constraint is a major innovation in fund management. Better products with higher information ratios will be on offer to clients. This comes at a time when clients are trying to maximise their investment returns and increase the relative balance of beta and alpha in their portfolios. Fortunately, the Ucits III environment allows managers to deliver these kinds of strategies and offer an attractive alternative to concentrated, higher tracking error portfolio strategies.
